By Chris Ebert

roseThe S&P 500 closed at an all-time high of 2123 this past week.

The Dow closed within a few points of its all-time high, as did the Nasdaq.

Each of those events taken out of context can seem to paint a rosy picture of the stock market; it’s difficult to argue with the market when stock prices are climbing higher than they have ever been before. However, put into the proper context the picture becomes one of gloom, and perhaps of impending doom.

There is and always has been an abundance of doom and gloom when stocks reach new highs. It’s simply the nature of the marketplace to always have a percentage of participants who interpret the economy as being one of decline, thus these participants are bound to see record highs in major stock indexes such as the S&P as being irrational, overbought, unsustainable, manipulated, dangerous, bearish, and any number of other adjectives. Record highs do not make sense in a period of economic decline.

Doom and Gloom can be Risky

A trader who joins the doom and gloom party can soon be faced with losses, even if the doom and gloom is justified, because the stock market is not the economy and the economy is not the stock market. They are two entirely different creatures. As such, economic decline can actually fuel rallies in stock prices, at least in the early stages. Obviously a period of protracted decline will eventually have a negative effect on stocks. The early stages of decline are different.

In the early stages, corporate earnings may just be beginning to falter, but are still relatively good. GDP, unemployment numbers, home sales or other tell-tale economic numbers may start to falter as well, but again the numbers are often relatively good when compared to a period of economic recession. When these numbers are made public, the news initially tends to act as a catalyst that drives fear and causes some traders to sell their stock positions. Stock prices often pull back.

The problem for traders, in the early stages of an economic slowdown, is that during a Bull market traders have been conditioned to buy the dip. Thus, any decline in stock prices, whether justified by a news catalyst or not, tends to get bought up quickly. Stock prices soon return to their highs, and in some cases surpass them, as happened this past week.

When stock prices climb back to their old highs, or exceed those highs, some traders on the sidelines will be enticed to buy stocks so as not to miss out on the rally. Others may actually have their hands forced, since those who short stocks may need to buy stocks to cover their short positions. In extreme cases, traders who short stocks may be required to buy stocks to meet margin calls during a rally.

Doom and Gloom is Sometimes Justified

The fact that all the buying drives stocks to record highs has nothing to do with declining economic conditions, except for the fact that the decline may have been the catalyst that precipitated the rally to new highs. The two events are otherwise unrelated. The doom and gloom is often justified, even when stocks do not reflect the doom and gloom. The only thing that is unjustified for a trader is taking actions in the stock market that assume the doom and gloom will immediately cause a decline in stock prices. It’s almost never immediate.thunderstorm

It is thus very easy for a trader to begin to second guess his own actions and interpretations of the market. On the one hand, doom and gloom can seem justified. On the other hand, the stock market does not seem to agree. This scenario can quickly lead to a lack of self-confidence for a trader. “What does the market know that I don’t?” becomes a common sentiment.

It is that very sentiment that can drive stock prices even higher. As traders lacking self-confidence capitulate with the rally, their actions add even more fuel to the rise in stock prices. This fuel is the reason that stock prices have long been said to climb a wall of worry. It’s not that worry is unjustified; rather that worry leads to a breakdown in self-confidence when the stock market does not immediately seem to carry the same sense of doom and gloom.

Surviving Stock Market Purgatory

For most traders, as long as position sizes are kept at a safe level, selling or shorting stocks while those stocks climb the wall of worry will not be devastating. Losses will occur as the market makes a new top, but those losses will be manageable. Self-confidence will decline, but as long as a trader stays focused the lack of self-confidence will not be crippling.

Staying focused requires a dedication to following the trend. If a trader believes the stock market is putting in a top, then the trader must be dedicated to acting in a way that demonstrates such a belief. As long as the trader has evidence to back up those beliefs, and as long as the trader accepts the fact that the stock market may act in a way that is counter to those beliefs for quite some time, then the competent trader can act on the sense of doom and gloom.

doubtTo be competent, all that is necessary is to be prepared for the consequences when the market’s sense of doom and gloom lags the individual’s. Selling or shorting stocks at a market top will often result in initial losses. These loses must be kept small enough to be manageable and also small enough not to erode self-confidence so far that the trader is tempted to capitulate the next time the market rallies. Market tops take time, and the wall of worry can be a tall one.

One way for a trader to regain some of that lost self-confidence is to find objective methods for verifying the sense of doom and gloom. Since stock options are one of the most objective instruments in trading, a study of options can be helpful in this regard.

The S&P 500 has risen fast enough over the past few years to give some option traders spectacular profits. Among those profiting were buyers of Long Straddles using $SPY or $SPX as the underlying. Long Straddles profit from a large move in stock prices, no matter what direction the stock prices move. Some of the huge rallies in past years were able to drive $SPY/$SPX Long Straddles to profitability. But those profits have since disappeared, and have been absent for months; and that provides some evidence of doom and gloom.

The disappearance of Long Straddle profits (known here as the Lottery Fever stage) is not in itself evidence that the stock market is suddenly a gloomy place. However, there is more evidence. Long Calls using $SPY/$SPX, particularly 4-month ATM Long Calls, have now stopped profiting as well. As can be seen on the chart below, Long Calls only profit in Stage 2 or Stage 1, something they have not done for a while, and something they did quite often until recently.

OMS 05-15-15

* All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an Exchange Traded Fund (ETF), the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) that closely tracks the performance of the S&P 500 stock index. All options are at-the-money (ATM) when-opened 4 months (112 days) to expiration.
EXAMPLE: If Long Call premium paid is $2 when SPY is trading at $200, the loss is 1% if the option expires worthless.

It’s still a Bull market; there’s no question about that. We are still setting new records for all-time highs in the stock market. But the lack of profits for Long Straddle and Long Call option trades seems to back up those traders who are sensing doom now. All-time highs that come during Lottery Fever are the antithesis of doom, but the recent highs occurred during Options Market Stage 3; and that’s not a good sign for the Bulls.

Because of the disconnect between the economy and the stock market, stocks seem to have had the wind taken out of their sails. They are drifting aimlessly now, perhaps waiting for the other shoe to drop. Nobody knows how many months will pass before that shoe does drop, or how many new all-time highs may be set during that time. But, for now the stock market seems to be stuck in Purgatory.

It may behoove a trader in Purgatory to remain self-confident. Stock market Purgatory is never eternal; it will end. And when it ends, a good trader wants to be on the right side. Capitulating with rallies is always a temptation during these situations, and those who do capitulate are often rewarded initially.

Those who hold fast to their beliefs of doom and gloom may find their rewards later, as long as safe trading management practices are followed. It takes all kinds of traders to keep the stock market running. Capitulators and doom-and-gloomers can all find a place. But, it pays for a trader to know which one he is.

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

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